Happy Thoughts

December 11, 2017December 11, 2017 ~ C.O.R.E. Beliefs ~ Leave a comment

Good morning.

I write more about our newest family member on my other blog CORE Beliefs but Kubae and I are so excited to welcome Ginger into our home! We picked her up Saturday from the Southwest Washington Humane Society.

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Here are my two wonderful young ladies. Yes, Ginger has her own pink bed, pink walking harness, pink extending leash and collar and even a pink car seat. She is a corgi-terrier mix, 6 months old and hates being separated from her “mommy”.

No, she does not sleep in her bed. It is funny, when we put her little bed on top of the chest, I told Kubae that our little sweetheart was going to jump into our bed within 5 minutes. No sooner did we turn out the lights than we heard her little paws on the foot rail and a soft plop as she hit the mattress. She curled right up between us! The good news is she sleeps through the night.

Moving on.

You have no doubt heard the various predictions about the tax reform bill that is currently in committee. You have probably even formed an opinion as to the effectiveness of this effort at tax reform. Sadly, your opinion is likely based upon your political disposition instead of really getting to understand what is being done.

When you hear that tax reform never pays for itself, be careful. I think the evidence is there that within a short time span the tax law does not spur sufficient growth to “pay for itself”. But I think there is a case that, over a generation, the tax cuts can be effectively stimulative. The bigger issue is if the pain and suffering are worth the wait.

The 1986 tax act was a major rewrite of the tax code. It did not really “pay for itself” in the first 5 or 10 years. I believe, however, that when we look at today’s tax receipts, federal spending and redistribution, we notice that our tax receipts are substantially higher than what they were in 1985.

More importantly, it changed certain behaviors by changing the incentives. Passive activities were no longer sought after for their generous tax breaks – unless one could find a passive investment that spun off income. Requiring social security numbers and birthdates for dependents de-incentivized the deduction of, shall we say, dubious dependents. Yes, I have heard that it created a far more complex tax code – I wouldn’t know for certain because in 1986 I was playing Marine – but I think overall it led to an economic improvement that has enhanced our lives and general prosperity.

As you measure the economic impact of the current tax reform measures, keep in mind that part of what we want to change is how certain behaviors are incentivized. One code section that comes to mind is section 121. IRC 121 is the home sale exclusion rules which state that if you own and live in your home 2 of 5 years, the gain can be excluded. I believe it was enacted in 1999 (or thereabout).

This was a huge benefit to home owners over prior law. The prior law required you to buy a home of equal or greater value than the home you sold. Unless you were over 55.

With this change, you could now sell your home and rent until you found the right property. If you moved from a high cost of living area to a much lower one, you would not have to fear being taxed because your new home was less in value, even if larger. It provided opportunity – that is, an incentive, to consider moving every few years instead of every decade.

Yes, as with all changes like this, there were lots of attempts to structure transactions to get the benefit without technical compliance. And there is a link between IRC 121 and the huge run-up in home values in the early 2000’s but I think, overall, that this “reform” served the economy better than under the old law.

Now, congress wants to update IRC 121 and incentivize people to live in their homes longer by requiring 5 years of 8 owning and living in the home. It remains to be seen if this is a positive or negative incentive – especially with an economy that possibly is going to require citizens to relocate for new job opportunities. But the point is, it might take more than 5 or 10 years to determine if a change helped or hurt the economy. And if, after 10 years, congress sees that it is perhaps not working as intended, I would hope they would try to correct it by having a fair and open debate. Ahh to be a dreamer.

As you read the opinions of your favorite pundits and listen to your talking tax heads, keep in mind that things change constantly. So, have a happy thought and don’t get wrapped up in the minutia of their debate. Updating the tax code is a good thing, although I do agree it could have been handled a little more maturely by everyone involved.

Deferred Tax and Tax Reform

December 7, 2017December 7, 2017 ~ C.O.R.E. Beliefs ~ Leave a comment

This is going to be entertaining.

We have a few clients that have substantial deferred tax assets – mostly from net operating losses (NOL) carried forward during their start-up period. Tax losses for corporations are typically carried back two years and carry forward 20. The problem is that when the adjustment was made, the assumed tax rate was above 25%.

Why is this a problem?

Lets say that a company had a $400,000 loss in 2016. The assumed tax rate for book purposes was 25% and so is carrying forward NOL of $100,000 from that loss. the adjustment to initially record this was

Deferred tax asset $100,000
Income tax benefit $100,000

The income tax benefit is part of the income tax expense (benefit) line on the P&L statement.

2017 was a breakeven year, no income or loss for book purposes so the tax expense (benefit) recorded is $0.

But there is a problem.

Congress is enacting sweeping tax reform which indicates that the new tax rates are going to be 20% for 2018 and beyond.

GAAP requires that assets be reviewed for impairment at least annually. Well, this deferred tax of $100,000 is an asset. So is it impaired?

Since the law has not been signed as of today, it is not set in stone. So one argument is that, since you are not sure of the actual change, you shouldn’t reduce the asset value. However, is it more than remotely possible that the tax law will change? And if so, should the impairment be recorded?

Since both houses of congress have passed a corporate tax law which reduces taxes and the president has indicated that tax reform will be signed, all indications are that corporate tax law will change. And since, in this case, the law is expected to be in force for 2018, it appears that new tax rates are more than remotely possible. It is probably a near certainty.

So what do we do?

I think businesses need to look at their deferred tax accounts and ask if the carrying amounts are correct for their upcoming year ends, even if the tax law is not passed prior to 12/31/17. Just as importantly, I think if your company has a September, October, or November year end you probably need to look at those accounts and determine if the amounts accurately reflect possible changes.

In this particular case the client should probably record an entry to reduce the deferred tax asset to $80,000. The adjustment would be in the current year as the original adjustment was correct given the known fact patterns. So an adjustment of the prior periods tax benefit would not be correct.

You will also want to make sure you either update your tax footnote or add one to explain the changes and how your company implemented them.

The good news is that this adjustment should not have a major impact on bank loan covenants as most base their covenants on EBITDA – earnings before interest, taxes, depreciation, and amortization. No matter what the tax adjustment, EBITDA won’t change.

However, there may be still be a gotcha to this as it appears there is possibly going to be a limit to the deductibility of interest expense. Latest read was that it was capped at 30% of profit before interest. If this holds up, then it is possible that, in the example above, there might actually be taxes due.

Lets say that the Company made $50,000 before interest expense. The interest expense was $50,000 which led to the breakeven. If they cap interest, then for tax purposes, taxable income is $35,000 (50,000 X (1-30% cap)) which leads to income taxes due of $7,000. But for book purposes, the tax effect was zero, leading to the $7,000 being added to the deferred tax asset – at the same time you are reducing it for the reduction in rates.

And you thought accounting was boring.

Like I said, entertaining.

Have a great day.

The tangled web of pass-throughs

December 4, 2017 ~ C.O.R.E. Beliefs ~ Leave a comment

No doubt like many a tax-nerd, I spent part of the weekend trying to understand the senate and house tax bills and their impact on clients. Obviously, it is a waste of time as there is no guarantee that either will become law as the tax acts are going to conference but, it is educational none-the-less.

I wrote the other day about how it works for individuals but now, what about someone who owns rental properties or other pass-through business?

Nothing I have read so far indicates that they are doing much in the way of changing the Passive Activity Loss (PAL) rules, so your investment in a rental property while probably still follow current law which means that you will likely not be able to take rental losses if you make more than $125K. On the other hand, if your rental is a Passive Income Generator (PIG), you could see some tax savings… maybe.

What you should realize is that the very generous immediate write-off for business purchases does not include buildings. You will still need to capitalize the purchase of rental property. And it appears that the tax life will likely remain as it is today – 27.5 for residential and 39 for commercial.

If your rental is a PIG and throws off $10,000 of income, your tax liability would be no more $2,500 under the House’s version as this one taxes pass-through income at 25% maximum. Obviously, if your total income puts you in a lower tax bracket, you would be taxed at that rate. The senate version, on the other hand, provides a deduction of 23% of taxable income. But as will all things tax-related, it isn’t quite that simple. It limits the deduction to 50% of wages paid.

Since this is a rental property, you will likely not have employees. Therefore 50% of zero is, of course, zero. Since this is zero, you would pay tax at your regular tax rate. Again, if you are in a lower tax bracket, it doesn’t really matter but, if you make more than $200,000, then you are in the 32% bracket and there really isn’t any savings.

The senate version is aimed at S Corporations and attempts to exert pressure on shareholder/employees to take “reasonable compensation”. But take the following fact patterns. Z Company has $1.0 Million of profits before taking into consideration officer wages. Z Company employs 50 employees and has $2.0 Million in payroll.

50% of $2.0Million is $1.0 Million. 23% of $1.0 Million is $230,000. Without the owner/officer taking payroll, they will get the full 23% deduction. It doesn’t matter that the owner did not take wages. For what it is worth, W2 wages could be as low as $560,000 in this example, with or without officer compensation, before the shareholder starts to lose the deduction.

Another problem is that both versions limit the types of businesses that can qualify. Professional services businesses will not get to take advantage of the lower rates since it is assumed that professionals do not employ others. So, take a doctors office: the doctor has a front desk person, an office manager, four nurses and the doctor. Six employees. Compared to a small contractor with a bookkeeper, a foreman and 4 laborers. Also six employees. If they both make the $1.0Million of profit and pay $600,000 in wages, the contractor gets the deduction of $230,000 and the doctor doesn’t. This is true even if the contractor works more hours than the doctor.

It will be interesting to see how the pass-through entity issue plays out in conference.

Have a great day.